Equity investments are generally considered to be riskier than fixed income instruments. Why and when are they more attractive than fixed income instruments?
A portion of the company’s equity (usually represented by a share of stock) confirms the investor’s right to a certain share in the company’s own funds. There are two main sources of return on equity – (i) stock price appreciation and (ii) dividend payouts. Price appreciation depends on the company’s financial success and demand for its shares on the market. Of course, appreciation in stock price is dependent on many factors – the company’s market position, the business insight of management, the effectiveness of operations, etc.
Dividends represent the second source of returns for shareholders and are considered a source of stable income. Dividends are not always present – some companies do not pay dividends at all (like Amazon, for instance). In contrast, some entities like real estate investment trusts (REITs) are obliged to distribute 90% of their profits to shareholders. In any case, it’s important to understand that dividends are issued solely at the discretion of the company. It is usually defined in the company’s dividend policy, but If the company is not performing well, it may be deemed necessary to reduce or suspend dividend payments. Usually, this cut or suspension in dividends is complemented by a stock price drop, exacerbating the investor’s losses.
Equity investors should first focus on to what extent they believe in the business perspectives of the company. There’s no guaranteed income for the investment in stocks – both the price appreciation and dividends are uncertain. But in exchange, equity offers compensation for assuming business risk in the company, as the price appreciation potential is virtually unlimited.
Fixed income instruments have different characteristics than equity. As evident from its name, these instruments offer some kind of reliable source of income. The simplest form of a fixed income instrument is a bond. Effectively, a bond is a contract where the issuer agrees to pay the buyer a predefined amount at the bond’s maturity (principal amount) and make interim payments during the bond’s existence (“coupon” payments). At the bond’s purchase, the investor may calculate the yield, which shows the income received over the life of the bond in relation to the price paid. There are some clear advantages of fixed income instruments over equity:
If the investor holds a fixed income instrument until maturity, he or she will earn the exact yield anticipated at the time of purchase (while this is true for instruments with a predetermined interest rate, some debt instruments may be more complex and the expected income may not be certain).
If the company goes bankrupt, shareholders are usually last in the line for compensation. However, when the company defaults on its obligations, a portion of claims are usually recovered in favor of the debt owner. Debt investors usually recover about 35% of their investment (with the exception of some types of investments, such as subordinated debt).
Some debt securities offer tax savings options in the same way municipal bonds do.
However, debt securities are subject to different types of risk. First, the interest rate risk reflects a change in a bond’s price when market interest rates change. Let’s assume that a zero-coupon bond has an 8% yield to maturity. If the yield on the market for equivalent securities declines to 7%, our bond should decrease in price to compensate for the difference in interest income. The magnitude of the decline depends on the bond’s duration, which takes into account the timing of its cash flows. The longer the duration, the more sensitive the bond’s price is to changes in yield. So, when the Fed raises the interest rate, fixed income securities generally decline in price.
Reinvestment risk is the risk attributable to fixed income instruments with repayments prior to final maturity. When yield to maturity is calculated in the beginning of the investment for fixed instruments, commonly-used conventional models assume that all the interim cash flows are reinvested at the same yield. However, this is not always the case, as market yields fluctuate constantly. Therefore, reinvestment risk reflects a potential loss of income since interim cash flows cannot be invested with the same yield. Examples of such interim payments are coupon payments and amortization of the principal.
Fixed income investments provide a more certain source of income, but offer no compensation for the participation in the company’s business risk. The principal of a fixed instrument cannot grow in the same way the stock price can. Again, it should be noted that there are more complex debt instruments with the potential for a change in principal, but they actually may not be considered fixed income instruments.
To sum up, fixed income instruments can be more suitable than equity in some cases, especially when a reliable rate of return is required. However, there is a vast variety of instruments, including subordinated (higher yields but less protection in the case of default), asset-backed (where the payout may be nearly guaranteed), and many others that should be carefully selected given the specific investor’s risk and return profile.